Did you get a shock one fine morning looking at the stock tickers or scanning the stock quote only to find your favourite stock having tumbled significantly compared to the price you last saw it trading at? At times, you are likely to be taken by such surprise if you do not track the corporate developments related to the company or did not carefully read the company notice that was sent to you.
One of the reasons for a sharp drop in the stock price could be that the company had announced a stock-split some time ago that got reflected in its market price. So what is a stock-split? We give you a lowdown on the mechanics of stock-split and how an investor should react to them.EXPERT VIEW: 8 deadly sins of investing
As is evident from the term itself, stock-split is a division of a share into shares with lower face value. The division takes place in a way that the total market capitalisation of the stock post-split remains the same. This in effect means that the total value of your holding on the day of the split does not change as the number of shares goes up.
But what does it mean for the future? After a split many new investors might like to buy the stock as it is available at a lower price hoping that they would stand to gain. Is that the right way to look at a post-split stock? Maybe not. Our research on 30 companies that went for stock splits during January 2001 to May 2010 show that exactly half of them moved up a year after the split while the other half witnessed a drop in price.
WHY STOCK SPLITS?
SPLITTING GAINS: Stock splits between January 2001 and May 2010 of 30 companies with over Rs 7,000 crore market cap as on May 9, 2011.
Stock splits are mainly carried out with the intention of increasing liquidity. Once liquidity increases, more buyers and sellers trade in the stock, which, in turn, helps to discover its true value.
Lalit Thakkar, managing director-institution, Angel Broking says, "The prime intention behind the stock split is to enhance liquidity in the stock and also to make the stock more affordable. This is witnessed more when the price of a stock moves up significantly. Thus, a stock split is usually resorted by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of peer companies."
For instance, on August 17, 2010 the stock of Housing Development Finance Corporation (HDFC) was trading at Rs 3,011.45. The company split the share in a ratio of 1:5 and the share price closed at Rs 621.20 on August 18, 2010 (post-split).EXPERT VIEW: How to hit a jackpot on stock market
In a stock-split, the outstanding shares are divided into specific numbers of predetermined shares and the liquidity of the stock increases. This is how a stock-split works. Suppose a company has 100 crore outstanding shares of Rs 10 face value and it announced a split to Rs 2 face value per share. Therefore, one share of face value Rs 10 will become 5 shares of Rs 2 face value. A person holding 200 shares of the company will have 1,000 shares after the stock split.
Udit Mitra, director, research, MAPE Securities, says, "If the fundamentals of a company remains same, there will be no impact on the value of your investment, but on the trading floor, as more floating shares are available for trading you expect market forces to determine the true price with a bigger volume. Hence, if the fundamentals are good, stock will trade up and vice versa."WHAT'S IN IT FOR INVESTORS?
If you own a stock that declares a split, the number of shares you would own after the split increases. However, the price per share reduces. This is because the market capitalisation remains the same. So, as an investor, though the price you get for each share actually declines, the total number of shares increases. Market capitalisation is calculated by multiplying a company's outstanding shares by its current market price.
In theory, a split should result in an increase in the number of shareholders as more investors would buy at lower prices.
BREAKING DOWN: Stock splits between January 2001 and May 2010 of 30 companies with over Rs 7,000 crore market cap as on May 9, 2011.
Avinash Gupta, vice-president, Globe Capital says, "Investors assume that there could be some benefit resulting from an increase in trading activity and the consequent price movement. They should try to understand the objectives of the split and the potential benefits as well as disadvantages."
It seems that a stock split may not automatically result in benefits for investors who bought the split share at lower price. One of the possible reasons for the increase in share price, if it happens, is that a stock split provides a signal to the market that the company's share price has been increasing prior to the split and people assume this growth will continue in the future.
However, the key parameter to be evaluated while investing in a company which has gone for a stock split is the valuations of the company or the underlying fundamentals.
For an overvalued company, chances are that it can see a decline in its share price after a 1:2 split. If we take the example of Ranbaxy, the share of the company was trading at Rs 1,039.55 on July 22, 2005 and it closed at Rs 504.40 on July 25, 2005 (post-split).
"It was trading at 32 times one year forward price-to-earning-ratio (P/E). The fundamentals of the company also deteriorated. Hence after the split, the stock underperformed," Thakkar added. Post-split, the share prices dropped around 29% to Rs 356.15 on July 25, 2006.SHOULD YOU INVEST?
An analysis by Money Today of the top 30 companies according to their present market capitalisation which underwent stock splits during January 2001 to May 2010 reveals that exactly half of them gave positive return during the oneyear period from the date of stock split. However, the rest of the stocks gave negative returns.
"The analysis confirms that the manner of slicing does not make the cake bigger. The price performance of the share depends on the state of the market and the fundamentals of the company once the transients settle down," Gupta added.
"The intention behind a stock split is to enhance liquidity and to make the shares more affordable."
Market experts believe that investors should look at the fundamentals of the company before taking a position immediately after a stock split. Avinash Nahata, head-fundamental desk, Aditya Birla Money says, "Stock-splits have a neutral affect on the price of a stock."STOCK PERFORMANCE
Let's analyse top two companies from our list, ITC and Bharti Airtel. The stock of ITC and Bharti Airtel split on September 21, 2005 and July 24, 2009, respectively.ITC:
ITC shares were split in the ratio of 1:10 and the share price of the company surged 33.45% to Rs 93.50 (post-split) during September 21, 2005 to September 20, 2006 after the split. On an average, the trading volume of shares of the company during April-September 2005 (till stock split) was at 1.04 lakh shares against 24.89 lakh shares for rest of the calendar year ended 2005.
During the June 2005 quarter, the company posted a net profit of Rs 558.30 crore, up 20.85%, against Rs 461.99 crore a year ago.Bharti Airtel:
The stock was split in 1:2 ratio. The share price retreated around 25% after the split from Rs 415.50 (post-split) on July 24, 2009 to Rs 313.70 on July 23, 2010. From January 1, 2009 to July 23, 2009, the average trading volume remained at 6.90 lakh shares against 20.13 lakh shares during July 24, 2009 to December 31, 2010. During the June 2009 quarter, the company posted a net profit of Rs 2,687.50 crore, up 31.30%, against Rs 2,046.79 crore a year ago.
"Mostly, the post split fundamentals of the company and investors' sentiments towards the company give direction to the stock price after the split," Avinash Gupta of Globe Capital added.
As our examples of ITC and Bharti Airtel suggests, in the case of stock split, chances are there that the stock can go in either direction. So, be careful and get the necessary updates of the company before investing.